Corporate Law Update

This week we look at a case of two directors who breached their duties by using a tax scheme to pay themselves management fees while their company was insolvent, as well as updated corporate governance and voting guidelines for publicly traded companies from the Pensions and Lifetime Savings Association.

Directors who entered into tax scheme breached their duties

The High Court has found that two directors, who entered into a tax mitigation scheme while their company was insolvent, were in breach of their statutory duties and could not rely on the Duomatic principle to ratify their behaviour.

What happened?

Not long afterwards, in 2011, the Government announced that FITs would be substantially lowered, which naturally impacted on SPVS’s business.

Despite this, the directors paid themselves substantial management fees, which were recorded as directors’ loans.

In early 2012, they enrolled SPVS in a tax mitigation scheme. During the remainder of 2012, SPVS made three contributions to the scheme. Through a series of complex arrangements between SPVS, its directors and the scheme trustee, these contributions were set off against the directors’ loan accounts, effectively removing the directors’ liability to pay any money back to SPVS.

SPVS went into administration in May 2013. It finally entered liquidation in November 2014.

The liquidator claimed against the directors to recover the management fees. He argued as follows:

SPVS was insolvent when it made the contributions. The directors were therefore under a duty under sections 171 and 172, Companies Act 2006 to put the interests of SPVS’s creditors first. They did not do this and so were in breach of their duties.

The contributions were really a form of remuneration. SPVS’s articles required all directors’ pay to be approved by its shareholders. That had not been done, and so the directors were in breach of their duties when they approved the contributions.

The directors responded as follows:

SPVS was in fact solvent when it made the contributions.

In any case, they had in fact turned their minds to the company’s creditors.

They were the only shareholders of SPVS and they had previously passed a resolution approving the tax mitigation scheme. This was tantamount to approving their pay under the scheme.

If that resolution was not valid, they had instead approved their pay under the Duomatic principle.

(The Duomatic principle states that, if all of a company’s members informally consent to a matter on which they could have voted at a meeting, that consent is as good as a formal resolution. The consent must be “informed”, however: the members must actually turn their mind to the matter.)

What did the court say?

The court agreed with the liquidator.

Briefly, it found that SPVS had been insolvent each time a contribution was made, and the directors should have been aware of this. This was particularly so, given that the directors were aware of the upcoming reduction in FITs and how it might impact on SPVS’s business model.

Because of this, the focus of SPVS’s directors’ duties under sections 171 and 172 had switched from its members to its creditors. The directors had not turned their minds to the creditors, and their behaviour was not objectively justifiable. The contributions by SPVS to the scheme essentially caused SPVS to incur substantial liabilities "out of thin air", merely so that they could be set off against the directors' loan accounts.

The judge did not agree that the shareholder resolution approving the tax scheme extended to approving the directors’ pay. Although the shareholders had approved the scheme, they had not approved the individual contributions to it.

Finally, the court found that the Duomatic principle could not apply for two reasons:

SPVS was insolvent at the time, and the members of a company cannot rely on Duomatic when the company is insolvent.

Although the directors had assented to the scheme contributions, they had not turned their minds to whether it would have required a resolution of SPVS’s shareholders.

Practical implications

The facts of the case are quite particular, and it packs a lot of legal points (including some not mentioned here) into a dense judgment.

However, it is a useful reminder for company directors and shareholders of the following:

A director’s paramount duty (under section 172, Companies Act 2006) is to promote the success of his company for the benefit of the company’s members.

As long as the director actually turns his mind to his duty, the test is subjective. A court will look at what the director actually and honestly believed.

However, if a director fails to consider his section 172 duty altogether, the test is objective. The court will measure the director’s conduct against that expected of a reasonable director. It may be difficult to show that a director met the objective standard if he never considered his duty in the first place.

Once a company enters the zone of insolvency, the focus of the duty in section 172 switches from the company’s members to its creditors. It can often be difficult to identify at what point this occurs. A director should therefore always remain vigilant as to his company’s financial state in order to discharge this duty properly.

As a result, directors should ensure that they always record their reasons for entering into any transaction carefully in board minutes.

Although it is no longer common for directors of a private company to obtain shareholder approval for their remuneration, a director should check his company’s articles first to make sure.

If approval is required, the resolution should refer specifically to the director and his proposed pay, and not simply refer to the overall architecture of the pay mechanism.

Although Duomatic can be a helpful lifeboat when approval is overlooked, it is in many ways a fragile principle and will not always be available. As a rule, directors and shareholders should follow proper procedure for obtaining approval for a given matter.

PLSA updates corporate governance and voting guidelines

The Pensions and Lifetime Savings Association (PLSA) has updated its Corporate Governance Policy and Voting Guidelines for the 2018 season. The Guidelines set out standards of corporate governance, principally for Main Market companies, and recommendations to shareholders on how to vote on resolutions.

The key changes to the Guidelines include the following:

The Guidelines recommend that the directors of a company prudently assess the company’s accounts to ensure they do not overstate the company’s capital.

There is now more detailed guidance on particular “areas of interest” for auditor and audit committee reports, including the level of materiality and evidence of professional scepticism.

The Guidelines recommend that shareholders consider voting against the audit committee chair and the auditor if the auditor has been in place for more than 20 years.

They also recommend that shareholders consider voting against the audit committee chair, auditor and audit fees if the auditor’s non-audit fee exceeds 50% of its audit fee in consecutive years without an adequate explanation.

The PLSA recommends voting in favour of share buy-backs, as long as they are a prudent use of a company’s cash resources and supported by the underlying business’s cash-flows.

The Guidelines contain a new section on “Sustainability”. This encourages shareholders to vote against the company’s annual report and accounts, or against re-electing the chair, if they believe key stakeholder relationships are being neglected.

Finally, where a company operates in a sector affected by climate change and fails to provide a “detailed risk assessment” of the effect of climate change on its business, the PLSA recommends that shareholders not support re-electing the chair.